A Taxing Dispute

The WTO ban on a U.S. export subsidy has pushed companies and Congress into a battle over tax bills.Alix Stuart, CFO MagazineAugust 1, 2003

Last summer, Corporate America stood united before Congress to plead for the preservation of some $5 billion in export-tax benefits. Those benefits have been associated with the foreign sales corporation/extraterritorial income (FSC/ETI) exclusions, a government-approved regime of tax shelters for foreign earnings. Ruled illegal subsidies by the World Trade Organization twice in the past five years, the exclusions are slated for extinction, and executives trooped to Capitol Hill to ask not for clemency but for reincarnation.

"The loss of ETI without a suitable replacement could undermine the ability of U.S. exporters to compete in a global trade environment," warned F. Lynn McPheeters, CFO of Caterpillar Inc. "If the FSC/ETI were repealed...certainly it would be very detrimental," echoed Dan Kostenbauder, Hewlett-Packard's general tax counsel. Pierre Chao, a senior adviser at Credit Suisse First Boston, predicted that loss of the tax break would chop billions off the market capitalizations of key exporters like Boeing and United Technologies, thanks to lower earnings.

Now, with the European Union resting its finger on the trigger of $4 billion in retaliatory tariffs to force ETI repeal, Congress appears to be responding to those pleas for a replacement. While the Bush Administration has vowed to comply with the WTO directive, "it's very unlikely [FSC/ETI] would be repealed with nothing in its stead," says Rachelle Bernstein, director of Deloitte & Touche's tax-policy services group. In fact, not one but two bills with replacement tax breaks are being crafted in the House, and the Senate may add a third.

What constitutes a suitable replacement, however, has been the subject of bitter debate. Domestic manufacturers like Caterpillar are pushing for a tax break linked to U.S.-based production, currently embodied in a bill sponsored by Philip Crane (R-Ill.), Charles Rangel (D-N.Y.), and Don Manzullo (R-Ill.). Global operators like HP and Coca-Cola, though, are hoping to seize the opportunity to write more-favorable tax rules associated with overseas subsidiaries, an effort now headed by Committee on Ways and Means chair Bill Thomas (R-Calif.). While the two goals are not mutually exclusive, together they would cost the government about $80 billion over 10 years, reckons Gary Hufbauer, senior fellow at the Institute for International Economics in Washington, D.C., far exceeding the $50 billion 10-year FSC/ETI tab.

Double TroubleAt the heart of the matter is an effort to keep U.S. corporate tax burdens in line with what foreign-based firms face. In general, unlike their foreign competitors, U.S. companies must pay taxes on all income they bring back into the country, regardless of where it is earned. Since 1971, though, exporters have been allowed to funnel sales through so-called domestic international sales corporations and then FSCs, then deduct portions of those foreign earnings from their taxable income. That system, revised four times up to the current ETI regime, creates billions of dollars of savings for companies that primarily manufacture in the United States but sell overseas. It has also consistently been deemed an illegal export subsidy by the WTO.

To escape the "export subsidy" label, U.S.-based producers like Caterpillar, Boeing, and Microsoft are backing the Crane-Rangel-Manzullo bill, which would lower tax rates by up to 3.5 percentage points, depending on how high a percentage of a company's total production occurs in the United States, and regardless of where the goods are sold.

While few actually oppose the bill, many consider it too narrow for an increasingly global economy. "We like the Crane-Rangel-Manzullo approach," says Kimberly Pinter, director of corporate finance and tax for the National Association of Manufacturers, "but we don't think it should be a choice between manufacturing benefits and international tax reform. We would like to see something that addresses both."

A broader reform of international tax laws is expected from the Thomas bill, which was due out in July after several months of delay. His bill is expected to repeal FSC/ETI entirely, with a shorter transition period, and to include corporate tax favors like an expansion of research-and-development tax credits, a one-year tax holiday allowing companies to repatriate foreign earnings at a tax rate of only 5.25 percent, and a modification of Subpart F to allow U.S. companies to benefit from sales subsidiaries located in low-tax jurisdictions like Singapore and Switzerland.

The Thomas approach is favored by Procter & Gamble, Coca-Cola, EDS, and many others, often for reasons that have nothing to do with FSC/ETI. Procter & Gamble, for example, is "not a major exporter, and thus the elimination of FSC/ETI benefits would not have a major financial impact on us," says spokesperson Doug Shelton. But P&G is supporting the Thomas bill, since "it would make important progress toward eliminating double taxation of profits from our international business activities," says Shelton.

Subpart F reform is a particularly hot issue for companies with overseas operations. Tax payments on foreign income can generally be deferred by reinvesting it in those operations, rather than repatriating it. That advantage, though, is tempered by Subpart F, a complex 1962 provision that forces companies to pay current taxes on "passive" overseas income — including export-sales income — regardless of when it is repatriated. Even Treasury officials concede that Subpart F imposes unintended tax consequences and complexity.

Interesting PoliticsFor that reason — and because Thomas largely has control over which bills get airtime in Congress — most experts expect his approach to win out. But not without a fight.

"The big question right now is whether Thomas can put together the reforms he wants and also begin to draw some kind of compromise with Crane, Rangel, and Manzullo," says Hufbauer. And of course, there's still the Senate to consider, where the manufacturing benefits have found some strong supporters.

While the issue makes for interesting politics, though, some say the economic impact won't be dramatic as long as the $50 billion isn't reabsorbed into federal coffers. "There's not a lot of concern about [the FSC/ETI exclusions] getting repealed without a replacement," says Bartlett Cleland, a tax-policy expert at the Information Technology Association of America, "so a number of companies are sitting it out and waiting for the legislation."

Of course, the ultimate question is whether the United States can come up with a meaningful measure in the EU's time frame. EU trade commissioner Pascal Lamy indicated in a May statement that the tariffs will be enforced on certain products starting January 1, 2004, "if there is no sign that compliance [with the WTO's ruling] is on the way" by this fall.

"Compliance," though, could mean as little as getting a bill passed by the House, say some observers. Plus, "there's so much two-way trade, it's hard to imagine the EU could actually retaliate as much as they're authorized to without biting their own hand," says William Reinsch, president of the National Foreign Trade Council, a trade advocacy group. The United States and the EU account for about 20 percent of each other's trade, with the United States buying $82 billion more from the EU in 2002 than vice versa. At most, Hufbauer expects the EU to offer "selective retaliation," rather than imposing the entire $4 billion worth of tariffs at once.

Worth Fighting For?The $5 billion in corporate tax breaks that the foreign sales corporation/ extraterritorial income (FSC/ETI) exclusions are estimated to offer may sound like a lot of money, but few companies actually see a meaningful piece of it. In 1999 (the most recent available data), only 0.04 percent of all U.S. corporations benefited from the FSC regime, with fewer than 200 companies claiming 87 percent of the total benefits, according to a report prepared for Senate hearings in July 2003. Not surprisingly, 90 percent of those beneficiaries were in the manufacturing sector; even so, only 0.48 percent of all manufacturers benefited.

"FSC has become just a special-interest tax break for some of America's largest corporations," charges Dan Griswold, associate director of the Center for Trade Policy Studies at the Cato Institute, a Washington, D.C., think tank. He contends that the export subsidies of the FSC/ETI are "economically unnecessary," based on a 2000 Congressional Research Services study using 1996 data that showed the FSC boosted exports by less than half a percent.